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Four ways mutual funds may be better than ETFs

ETFs are a good thing, but mutual funds are somtimes better.

(Raffi Anderian / Toronto Star illustration)

By Dave PatersonSpecial to the Star

Sun., July 14, 2013

Exchange traded funds (ETFs) have improved the world for investors in much the same way that sliced bread changed things for sandwich lovers. They took a good thing, mutual funds, and made them better by cutting the cost, having full transparency, and letting you buy and sell them whenever you want.

Still, there are a few situations where mutual funds may be the better choice.

Let’s take a look at four of them.

You have a small portfolio: It’s pretty tough to argue against ETFs having the advantage when it comes to cost. Management fees are only a fraction of what is charged by mutual fund. Often lost in the discussion are the commissions that you will be charged to buy and sell an ETF that will range between $10 and $30. It doesn’t sound like a lot, but if you’re setting up a small ETF portfolio, it can add up fast.

For example, to set up a small $5,000 ETF portfolio with four ETFs would cost you between $40 and $120 in commissions. Put that in percentage terms and you are paying between 0.8 per cent and 2.4 per cent of your portfolio in commissions alone. If you go with no-load mutual funds, you don’t pay any commissions.

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Obviously there comes a point where it makes more sense to go with ETFs. That depends on a number of things, including how many ETFs you want to buy and how long you intend to hold them. I’d suggest that at $25,000 ETFs start to look much better.

You make regular contributions: If you’re like a lot of people, you rarely have a big chunk of cash kicking around to invest, so you put a bit away each month. If you put these regular contributions into ETFs, you’re going to be dinged with those nasty commissions that we talked about. In this case, it hurts even more. If you contribute $500 a month and pay $10 a trade, over the course of the year, you would pay $120 in commissions. That works out to a cost of 2 per cent. That’s mutual fund territory. The same math holds if you’re taking money out at regular intervals.

Most mutual fund companies will let you set up these plans at no cost to you. I should also point out that Blackrock’s iShares offers these plans on a few ETFs. Not all are eligible, so you’ll want to doublecheck before you invest.

You want to take cash out: After spending years building up your nest egg, there will come a time when you want to start enjoying it. To do that, you’ll need to generate cash flow. You can set up a regular withdrawal each month, and be dinged with a commission. Or, you can do this through the distributions your investments generate. There are a handful of ETFs that pay out juicy yields, the drawback being they are often in very specific sectors and can be quite volatile. Mutual funds offer what are known as T-Series Funds where you can receive a monthly distribution that will give you 5 per cent and 7 per cent back on an annualized basis. The distributions are treated as return of capital, so you don’t have to deal with the tax consequences until you sell out of the fund. They are not for everybody, but can be a good solution for those looking for cash flow.

If you are in a taxable account: ETFs by and large are more tax efficient than many mutual funds. This is because they don’t often pay the big capital gains distributions you see with some mutual funds. Still, they do pay distributions, and if you’re in a taxable account, you’ll be on the hook for the taxes. In some cases, mutual funds, specifically corporate class mutual funds, can be a better choice. I did a comparison for a client, looking at the iShares DEX Universe Bond ETF compared to the Dynamic Advantage Bond Corporate Class Fund. On a before-tax basis, the advantage was clearly in favour of the ETF. After taxes however, it was the mutual fund in the lead, by a big margin no less. I have looked at other scenarios and the results are similar, with ETFs posting better pretax returns and funds taking the lead after taxes.

There are certain markets, for example emerging markets, small caps, and Canadian equities where the markets are very concentrated or inefficient where a high quality active fund may be the better choice over an ETF. Regardless, the key is to build your portfolio using the products that work best for your situation. Sometimes it will be funds, sometimes ETFs.

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